A Pivotal Test Looms for Crude Oil

by Tyler Craig | September 24, 2013 11:38 am

A Pivotal Test Looms for Crude Oil

Since spiking on the Syria conflict, crude oil has quietly receded from the limelight. For a time there it seemed as if the energy commodity was poised for an outsized move to the upside, but a peaceful resolution to the tragedy in the Middle East has taken the wind out of crude oil’s sails.

Over the past month, crude oil has fallen back to the lower end of its three-month range near the $103 level. Now we shall see how much conviction oil bulls truly have. Will they come out in force and defend their domain, or will the persistent selling pressure prove too much, resulting in a fresh breakdown to new multimonth lows?

With crude oil cracking slightly below $103 in early trading Tuesday morning, the sellers still appear well in control.

The downturn in crude oil prices has been equally matched by a downturn in the implied volatility for the popular oil ETF — the United States Oil Fund (USO[1]). Initially, the Syria turmoil injected a massive dose of demand into the options market driving the CBOE Oil VIX (OVX[2]) to its highest levels of the year around 31.5%. As time has passed and the odds of a military strike in the region have diminished, would-be options buyers have exited the market in droves, driving the price — and thus the implied volatility — of USO options back down to normal levels.

If you view the ongoing crude retracement as a buying opportunity, consider selling out-of-the-money puts on USO once we receive evidence of a rebound. You could wait until USO breaks above a prior day’s high, for example. The cheaper price tag of the oil ETF keeps the margin requirement for the naked put relatively low, which provides an appealing return on investment.

Due to the prevailing levels of low implied volatility, it’s tough to find any puts in the October cycle worth selling, so we’re going to have to use November options to structure the trade. Currently you can sell the Nov 35 put for around 55 cents. The max reward is limited to the initial credit received and will be captured provided USO remains above $35 by November expiration.

The max theoretical risk is limited to $34.45, but can be drastically reduced by exiting early if USO breaks below the strike price ($35).

As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.